A Look Into the Monetary Policies During the Great Recession and the Great Depression - Part 2

2 Background of the Events that Led to Both the Economic Downturns

There were many similarities between the two greatest economic downturns, not just in terms of the free fall of the economy, but also the factors that led to it. Below is an explanation of the situation that existed before, during and after each of these downturns.

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2.1 Great Depression

To get a better understanding of the causes of the Great Depression, it is important to take a look back at history to see how the economic system changed and what other factors came into play before the depression, and how these factors eventually led to the Great Depression.

2.1.1 Economic Events Before and After the War

During the last hundred years preceding the Great Depression, many changes have taken place in the terms of economy in the US. In fact, the external conditions were in a state of change throughout. For example, the introduction of steam and machinery changed the face of the manufacturing system, while the introduction of new modes of transport such as cars and ships opened up new areas that were unexplored until then. As a result of these changes, new cities developed, and this led to more demand for goods and service. Consumption increased, and along with it, the economy prospered on all fronts. Around the same time, there were new sources of raw materials, food supply and labor, and this led to an overall boom in the economies of most countries around the world (Robbins, 2007).

At this time of intense economic activity, the world saw its first set back, in the form of the First World War. This war had a profound impact on all aspects of life, including political and economic spheres. Also, this led to fundamental shifts in the demand and supply conditions. For example, during the war, there was a big need for war equipment and machinery, so companies spent raw materials and labor on creating these products. Once the war ended, these products became useless, that in turn, affected the companies engaged in the production of these equipment. Such changes in economic demand and supply created a sense of disequilibrium within the economy.
In this sense, the resumption of peace led to a disruption of the world market that had adapted itself to war conditions during World War I. Firstly, the demand and supply conditions were discontinuous, and this led to the destruction of vast amounts of capital. The second aspect is that there was a restriction on free economic activity, as most of the factors of production were devoted towards the production of a few products, mostly those that were needed for war. Therefore, when peace ensued, there was a reduction in the productivity of the factors of production because they lost the skill and knowledge needed to produce other kinds of goods needed for peaceful times.

Along with these structural changes, the economic system as a whole lost its capacity to adapt to the new times. For example, the centralized control of operations, authoritarian fixing of wages and labor costs, rationing system for the common public and the principles of collective bargaining had no place after the First World War ended. Therefore, the need to make some fundamental changes weakened the overall economic system and reduced its resilience and flexibility to handle problems.

Another factor that contributed to some extent to the economic problems is the break-up of the international monetary unit. For forty years before the war, all countries followed the international Gold Standard. What this meant was that the trade between countries was based on gold rates. This system offered a great degree of stability then because the price of gold had only minor fluctuations. Therefore, the price, cost structure and mobility of capital were in an equilibrium, until the war began.

During the war, most countries other than the US, abandoned the Gold Standard. Furthermore, many countries suspended the rights of effective convertibility and even inflated their economy to finance the war. As a result, gold supplies were confined to the central banks of different countries while prices rose in the countries that had inflated their economies. Therefore, the economic means of production went into disequilibrium.

After the war ended, many countries began to focus on their economies with the primary goal of balancing their budgets and bringing their currency into order again. By the end of 1925, almost all major countries including Great Britain began to follow the International Gold standard, with France being the only exception. However, the gold standard that existed before the war and after the war, were not the same.

By the end of 1913, the gold standard was at its peak because governments began to accumulate large amounts of it (Wheelock, 1992). However, after the First World War, that situation changed. One of the main reasons for this changed position of the gold standard was the dangerous liquidity position of the Bank of England, and the gold exchange standard that prevailed then. A run on the British Pound forced the British government to place exchange controls, that in turn, weakened the gold standard. Though Britain did not legally suspend the exchange, the implicit controls changed the role of the gold standard.

Prior to the First World War, Great Britain used the gold standard to its own advantage. Every time it had a problem with its balance of payments, it raised bank rate, and this led to a rise in other lending rates as well. As a result, it caused a reduction in the holdings of inventories that in turn, curtailed other investment expenditures. Such measures helped to adjust the balance of payments deficit. Secondly, there was no actual flow of gold, rather the adjustments consisted primarily of transfers of currencies from one country to another. After the First World War, there was a real flow of gold, and these flows were used to meet short-ter obligations. In sum, the gold standard that existed before the First World War and after the First World War was vastly different.

As a result of the changes in the gold standard, the inflation rates were up in most industrialized nations. Price levels doubled in the US and Britain, increased three times in France and four times in Italy. In general, the inflationary rates in the Europe were higher than the US, which meant, the cost of goods was lower in the US when compared to Europe. Therefore, the demand for American goods increased because it was cheaper than European goods, and this also helped to a manufacturing boom in the US.

In fact, this revival of the manufacturing industry after the First World War led to one of the biggest booms in the US economic history. Trade revived within and outside countries, incomes rose, unemployment levels fell, and production levels went by unprecedented levels. This increased demand for American goods and the resultant manufacturing boom caused stock exchanges to become prosperous centers that made many people rich. It was also the time for entrepreneurial spirit to grow around the world, as people went about developing their businesses to satisfy the growing demand for goods and services, and in the process, the national economies grew too.

2.1.2 Beginning of the Great Depression

Though the boom changed the face of some countries like the US, the widespread economic development and growth was not universal. For example, the manufacturing activity in Great Britain was only modestly good while in some European countries like Austria, a state of disequilibrium continued to persist. Germany, on the other hand, began to monetize its debts, and this led to high levels of inflation within the country. As a result, there was a peculiar state of monetary disequilibrium that had an underlying current of constant volatility. “Thus, in spite of the appearance of considerable prosperity and a very real measure of the revival of trade and industry, the period immediately preceding the slump was not without conditions which might justifiably have given rise to very grave anxiety. Clearly, if the forces making for prosperity were to slacken, the ensuing depression was likely to be a depression of more than usual severity” (Robbins, 2007, p.10).

The first signs of weakness in the US economy emerged in 1929. The Federal authorities knew by the February of 1929 that the prevailing boom, some of which were highly inflated, was inevitably going to lead to a crash. This understanding led to private warnings and other official and unofficial indications such as the rise of discount rates. Despite these signs, the value of stock markets just kept going up because the Fed did not provide strong indications that the economy warranted. Such a boom went on until the Hatry Group of the UK fell in September 1929. It all happened when Clarence Hatry, a successful entrepreneur wanted funds to expand his business. Many banks in the UK refused to lend because they were expecting a fall in the markets soon. To get his hands on the funding he wanted, Hatry began to issue fraudulent stocks, where the same certificate was printed twice, to give it to different people. When the fraud came to light, the London Stock Exchange suspended the shares and trading of the Hatry Group which was estimated to be ₤24 million at that time. This suspension led to a tightening of the financial markets around the world (Galbraith, 2009).

Such a tightening of markets paved the way for the crash of many stock markets around the world. The Dow Jones Industrial began to drop, and nine days later, it also crashed, though in this case, the failure of the Hatry Group was not the only reason. There were several underlying weaknesses in the economy, and this crash in the UK markets precipitated the crisis in the US markets..Earlier in September of 1929, markets peaked, and the Dow Jones Industrial stood 381.17, up about 27 percent from the previous year. On October 24, known as Black Thursday, the Dow Jones Industrial fell by 11 percent during the last hour of trade. It is estimated that thirteen million shares were exchanged on that single day, making it the largest day ever for transactions. The next day, the US president went on the radio to assure the people that everything was fine because he touted that the American economy was fundamentally strong and stable.

After that came Black Monday on the 28th of October when prices began to fall again. Companies that were believed to be infallible such as General Electric began to drop hard and fast. By the end of the trading day, the Dow Jones dropped by more than 13%. On Black Tuesday, all hell broke lose because within the first thirty minutes, three million shares were exchanged, and as a result, more than $2 million simply vanished. By the end of the day, the Dow Jones saw another 10% drop.

It is estimated that a total of $25 billion, today's equivalent is $319 billion, was lost in the crash of 1929. Though the markets finally bottomed out on November 3, 1929, the markets continued to slide further down, though at a much slower pace than Black Monday (Suddath, 2008).

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